Saturday, December 14, 2013

Geoinvesting is a bunch of short-sellers who I grew to respect during the great era of picking off Chinese reverse merger scams. They got several right and the ones that they got wrong (notably on Zhongpin) they were I believe right on most of the analysis.

Yesterday they came out with a "hit-piece" on Seeking Alpha on Amtrust Financial Services. This is a complicated, high growth, multi-jurisdictional insurance company. For most people a black box. For me it is home turf. Most my career I was a bank and insurance analyst (and the first 200 or so posts on this blog are about financial institutions). [Check my title here if you want career details...]

Amtrust is clearly a worthy candidate for examination by a short-seller. Several of the executives have colourful backgrounds and it is in a bunch of difficult, even problematic businesses. The first problem is identified by Geoinvesting. The second not so much.

One business that they are in - and one responsible for a large proportion of the growth - is California Workers Compensation, sometimes written (and any insurance junky will tell you this is problematic) through Managing General Agents.

Other businesses are also difficult, eg life settlements or buying of in-force life-insurance policies, in this case originally written by marginally problematic insurance companies.

They are also in the slimey business of offering warranty extensions on electronic goods sold through second tier retailers. [Anyone who buys the warranty extension is an idiot, and many of these are missold leaving all sorts of liabilities behind.]

But the real warts in this business (and there are many) are simply not identified by Geoinvesting - and instead they make howling error after howling error in their report.

Howler one: accusations of reinsurance accounting fraud by someone who does not understand what is meant by "ceded losses"

The allegation in the Geoinvesting report is that Amtrust has - and I quote:

From 2009 to 2012 we believe that AFSI has not disclosed a total of $276.9 million in losses ceded to Luxembourg subsidiaries.

What Geoinvesting mean by this is that they believe that Amtrust has simply failed to recognize in their consolidated P&L $276.9 million in losses.

This is a total misunderstanding of what is meant by "ceding losses". To explain I need to explain reinsurance a little (though in this case with some help from the very well written Wikipedia article):

When an insurance policy is written the insurance company "writer" will recognize as an asset the premium received. They will also recognize a "loss reserve" an amount being the amount they will expect to pay out on the policy over time.

This "loss reserve" is not a loss. Its simply a reserve for future payments. Whether the policy makes a profit or loss will be determined as the decades roll on. [If it is a workers compensation policy for instance an insurer may be paying an injured worker's medical bills thirty years hence...]

In a typical (and in this case proportional) reinsurance arrangement, a reinsurer takes a stated percentage share of each policy that an insurer produces "writes". This means that the reinsurer will receive that stated percentage of the premiums and will pay the same percentage of claims. In an accounting sense this is called "ceding the loss" and "ceding the premium" to the reinsurer. The reinsurer also recognizes no loss in the P&L. The gain or loss of the policy is recognized over decades.

In addition, the reinsurer will allow a "ceding commission" to the insurer to cover the costs incurred by the insurer (marketing, underwriting, claims etc.).

Geoinvesting has simply added up the "losses ceded" to the (internal) reinsurers and wondered why the "losses" did not wind up in the P&L.

This is profoundly amateurish.

It must be galling for the management of Amtrust to be accused of reinsurance fraud by someone who does not appear to be able to comprehend the basic Wikipedia article on reinsurance.

Life settlements

Life settlements are a business with a reputation for scumminess. It is the business of buying life insurance policies for more than their surrender value but less than their face value.

There are legitimate reasons for life settlements. Insurance companies are parsimonious slime-balls on the surrender value of a life insurance policy. They consider surrender a significant source of profit.

And some people might want to cash their life insurance policy - for example someone with terminal cancer and big medical bills may wish to cash their life policy so that they have money to pay their bills before they die. And the insurance company won't offer anything like fair value for a policy which is about to be claimed on.

But the reputation for scumminess is also deserved. In the early days of the HIV epidemic there was no test for HIV and men who visited "bathhouses" in San Francisco had low life expectancies. There were viatical companies who encouraged these men to buy policies which they immediately purchased from them at a premium. Of course they encouraged the men to lie about their sexuality. This was fraud against the insurance companies pure and simple.

It turns out that life settlements, particularly of the scummy variety, was not as good a business as it seemed. Insurance companies sometimes successfully persuaded the Feds to knock down your door and "examine" your business. But just as bad, policies that once traded at a premium (eg men with HIV) turned out to be worth less than was expected. HIV patients once had a two year life expectancy. The new drugs have extended that sometimes to more than twenty years. The life settlement company expected to collect a big fat policy. Instead they wound up paying twenty years of unexpected premiums.

Life settlement businesses (sometimes called viatical businesses) are justifiably controversial. Many have not turned out that well for investors.

Anyway Amtrust is in the life settlement business.

Here is what Geoinvesting say about it.

AFSI appears to be boosting earnings and tangible book value by marking up its portfolio of life settlement contracts ("LSCs"). LSC, net of non-controlling interest now represent approximately 19% of AFSI's tangible book value. In valuing an LSC portfolio, the discount rate and life expectancy ("LE") are the two most critical inputs. AFSI uses a 7.5% discount rate to value its LSCs while peers use a rate approximately 20%. Applying industry standard discount rates would result in a mark down of $90-135 million, or roughly 13-19% of AFSI's tangible equity. Further, it appears that AFSI relies on internal estimates, only considering third party estimates for the LE input (See 10-Q for the period ended September 30, 2013, page 17). In contrast, best practice is to use third party estimates to determine LE estimates and weight them towards the more conservative estimate. The use of internal LE estimates has been a staple of past frauds in the LSC industry (notably,Life Partners and Mutual Benefits).

AFSI has been revising down its LE assumptions, generating gains on its LSC portfolio. Publicly traded peers are revising their LE assumptions higher (especially for the premium-financed LSC paper that AFSI holds). Simply put, peers are assuming people are living longer while AFSI assumes people are going to die sooner. We are unaware of any reason why AFSI is taking a non-consensus view on lifespans of Americans. It is possible that AFSI's policyholders en masse have decided to take up smoking, skydiving, or ride motorcycles without their helmets, but given a diverse base of people, this seems unlikely despite what AFSI management is asking the market to believe if you accept its LSC valuations.

More than half of AFSI's LSC portfolio consists of contracts where Phoenix Life Insurance is the issuing carrier/counterparty . Faced with possible bankruptcy, PNX has been attempting to induce holders of its LSC paper to lapse on their policies by hiking premiums & denying death benefits. Given the possibility that PNX death benefits will not be paid, when PNX paper does trade, it trades for pennies on the dollar.

Now lets examine AFSI's rhetoric. They say dismiss changing life expectancy expectations as follows: it is possible that AFSI's policyholders en masse have decided to take up smoking, skydiving, or ride motorcycles without their helmets, but given a diverse base of people, this seems unlikely despite what AFSI management is asking the market to believe if you accept its LSC valuations."

Okay - well here are the policies and their assumptions as per the linked 10-Q:

The fair value of life settlement contracts as well as life settlement profit commission liability is based on information available to the Company at the end of the reporting period. The Company considers the following factors in its fair value estimates: cost at date of purchase, recent purchases and sales of similar investments (if available and applicable), financial standing of the issuer, changes in economic conditions affecting the issuer, maintenance cost, premiums, benefits, standard actuarially developed mortality tables and life expectancy reports prepared by nationally recognized and independent third party medical underwriters.

This seems pretty generous. Usually with a life insurance policy you would estimate values off some actuarial table and hope laws of large numbers mean you get it approximately right.

This company is different. Here is the details on the policies:

September 30,2013

December 31,2012

Average age of insured

79.9 years

78.8 years

Average life expectancy, months (1)

133

139

Average face amount per policy

$

6,669,000

$

6,770,000

Effective discount rate (2)

14.2

%

17.7

%

Yes - the average age of the insured is 79.9 years. They are old fogies. And their life expectancy is estimated as an average of 133 months or another 11.1 years. The company is assuming their life policy holders will live to an average of 91 years old.

Now this does not strike me an inherently implausibly low life expectancy - a life expectancy that geoinvesting could plausibly send up by wondering if these people (old fogies) have suddenly decided to take up skydiving. On these numbers it does not look like Amtrust is manipulating down the life expectancy to make their life-settlements business appear overly profitable.

In fact it looks like the opposite. At 31 December 2012 the average age of insured was 78.8 years and they were expected to live another 139 months which would place them an average age at death of 90.4 years. Now they are expected to have an average age at death of 91.0 years. The company has lengthened the average life expectancy which lowers the expected value of these policies. Geoinvesting argue they have manipulated life expectancy data to increase stated profit. The reverse is true - the changes in their life expectancy assumptions have lowered their expected profit.

There is a word for what Geoinvesting asserted: wrong.

Policies with a $6.669 million average face value against 79.9 year olds are clearly worth a lot of money. Perhaps it is unreasonable to chose your own life expectancy on each individual policy based on your assessment of their medical condition. But in this situation case-by-case assessment does not seem unreasonable. The 10-Q reveals precisely 272 policies in the book. That is all the business is... and it is likely that Amtrust has good data on all of its insured.

Geoinvesting is scathing about the 7 percent rate used to discount these policies (to determine their value) and compare it to high rates at other companies. I disagree. Other companies do things like buy policies from young people who have cancer. These people have a high risk of dying - but they also have (from the perspective of someone who is betting on their death) a high risk of surviving. A high discount rate is appropriate for these people. By contrast Amtrust is betting on 80 year olds dying pretty soon. I figure that is a safe bet and a low discount rate seems appropriate. 7 percent doesn't seem unreasonable.

Geoinvesting has a point though about a substantial proportion of the policies being against a single insurer, Phoenix. Phoenix after demutualization grew like crazy by selling underpriced insurance policies (not a good idea). These underpriced policies prompted viatical companies to encourage people to take insurance that they would in turn purchase. Phoenix continued to grow. It wound up with a large book of business and a buoyant stock price. Unsurprisingly it invested the loot badly and in collapsed in the financial crisis. The stock price is a shadow of its former self and it has not filed SEC accounts for over a year. [The old accounts have been withdrawn and will be restated.]*

Moreover Amtrust owns policies on people with an average age of almost 80. Surely some of them have died. So far they have not had any trouble collecting - the idea that these policies should be held by Amtrust at pennies on the dollar is ludicrous. But that is what Geoinvesting is suggesting.

Dangerous business

I don't want to pretend that Amtrust is a good business or that it is a bottom-drawer investment that you can safely put away for thirty years. It is not.

For instance they have been growing very fast in the dangerous game of California Workers' Compensation Insurance.

California Workers Comp has left a graveyard of dead insurance companies including some from Australia. Its an ugly place to do difficult business.

The first reason is a technical one: California Workers Comp policies are - by law - unlimited. When you buy auto or liability insurance there is almost always a maximum claim. The insurance company can bound its risk - and if - perchance you crash your car into a Rolls Royce showroom (causing $20 million in damage) your insurance company will cover you for damages up until the cap. But in California you might wind up with $40 million damages on a single policy. [Imagine the medical and care bills for a quadriplegic who lives another 45 years...]

The second reason why California is difficult is persistent "social inflation". The things an (unlimited) insurer is meant to cover have increased over the decades with Californian social mores. Think about "diseases" like fibromyalgia or carpels tunnel syndrome. Combined with increasing life expectancy for some injured (eg paraplegics, carpels tunnel "victims") this has been expensive.

The third reason that California is difficult is that the (state) insurance regulator is very competent at grabbing and securing your assets for the benefit of policyholders and not for the benefit of shareholders.

These things however take decades to play out. A typical California workers comp insurer seems to be extremely profitable on the current book of business but finds that old business produces old liabilities (eg carpels tunnel from white-collar workers who were originally thought to be and priced as low risk). The bad bits of the business grow over time.

The way Amtrust has been growing is by buying the renewal rights for insurance companies that have gone bankrupt. For instance they purchased the renewal rights from Majestic.

These will produce a business that looks really great now. And it will compound very nicely. In year one you have only the earnings from year one. In year two you have those earnings plus the earnings on the assets backing claims from year one. So on for year three. Profits grow at a super-fast compounding rate.

In the end it is difficult though because in the end every old insurance company winds up with old liabilities and in the case of California workers comp there is a reasonable chance the old liabilities kill you.

And in this case it might be particularly difficult. After all the customer list was purchased from a bankrupt company. It is unlikely to be a low risk or easy to price book of customers.

Why this is the perfect candidate for a short-squeeze

I have seldom seen a better candidate for a short squeeze. There is a large short position in the stock.

Some short-sellers however do not understand what they are short. They probably found the colourful people and built a story around it. The published short-thesis is incompetent.

Moreover the company is growing really fast in several businesses like California Workers Compensation. These may be (and probably are) very bad businesses that will eventually cause the company huge problems - but we may not know about these problems for a decade. It may actually wind up quite well. California may even have "social deflation". It seems unlikely but a decade is a long time and surprising things might happen.

There were several subprime mortgage companies run by colourful people in 2001. They wrote bad business and it eventually killed them. But if you were short the stock from 2001 you were pulverised. I would be receptive to a story that said you should short this company but you would have to argue that it was (say) Conseco 2001 not Conseco 1990. That is not an argument that Geoinvesting even attempt.

Meanwhile I went and took a small long. Its not a business I am comfortable owning long term but when I see people who are loudly incompetent in markets I want to get on the other side.

John

*When Phoenix collapsed it spun out a good business: Virtus Asset Management. This was one of the more successful investments in the history of Bronte. Check out the chart. We got moderately familiar with Phoenix and its parts.

Monday, December 9, 2013

Interoil is perhaps the most-disputed stock I have ever witnessed. The dispute is about the value of a huge claimed gas find in Papua New Guinea.

When short-sellers get together the conversation seems to inevitably turn to Interoil.

If it is a fraud (as many shorts will have you believe) it is a very long running one and one that can demonstrate impressive flows of gas (flares that make a huge noise and sometimes burn hundreds of feet high).

These flares make the shorts look - well - stupid.

If the gas is real then it has been uniquely hard to get a serious oil company interested. There has been announced deal after announced deal for about a decade - all of which have come to naught.

These deals and their subsequent failures make the Interoil bulls look - well - stupid.

The big announcement

On Friday Interoil announced its long-awaited deal with a major that may lead to the liquefaction of their huge claimed gas deposits in Papua New Guinea. The major is Total (the French supermajor). Total didn't figure very high in the gossip prior to this deal.

This is a big black-eye for the shorts. Total is committed to spending over half a billion dollars just to get options over the gas in this field. For the shorts this was not meant to happen. The stock may be down almost 40 percent on the deal but it is hard as a short-seller to find comfort in a big and presumably competent oil company stumping up real money to buy a gas field that you previously believed was worthless.

But it is also a big black-eye for the longs. Total is stumping up real money - but not much compared to what the bulls thought the field was worth. Incremental TCFs of gas beyond the minimums are sold to Total for $100 million a pop. My first thought when I saw that number: they left a zero off.

The stock was down hard for a reason. If the gas find is as good as Interoil claim it is then the management sold it for a song.

There are smart shorts and smart longs in this stock. I swear there are.

Today they all look stupid.

The shorts may claim victory - but they look stupid too.

John

Disclosure: Short. I made a profit but look stupid. Hey, its not how smart you are that counts.

Wednesday, December 4, 2013

My first job in financial markets was working for a true genius. It was a tough gig.

Even tougher was that I was the bank and insurance analyst - and banks and insurance companies are black boxes for almost everyone and dimly lit rooms of mirrors for an accounting junky. There are some people who do it really well but it isn't easy. The first 150 or so posts on this blog are about financial institutions - and whilst I can look back on those and be proud I sometimes wonder why I contributed so much intellectual effort to an area where exceptional returns are so difficult.

One of the big changes when we founded Bronte was that we were going to stick to stuff that was relatively easy. There are no prizes in investing for degree of difficulty. If the story is really complicated we are generally not that interested. Simplicity has worked for us too. Our returns have been more than adequate.

However I still admire people who are prepared to tackle the really hard financial problems - to do the difficult stuff. There are no prizes for degree of difficulty but we can admire it.

And so I lead you to Roddy Boyd writing about Brookfield Asset Management. BAM is as black-box as they come - and peering into this one requires discipline and hard work and all you see is through that glass darkly.

If you, like me, are attracted to feats of high-skill financial journalism read Roddy's piece. Darn good fun too.

However, this is not a book about Warren Buffett. The unknown Buffett doesn't even rate a mention. It's a book about fraud and fraudsters and the dupes that allow them to thrive.

And that is a story that is plenty relevant today.

===

1963 was a different world. Agricultural commodities were king. Twenty thousand tonnes of tallow (hard fat from meat often used in making soap) cost an amount sufficient to bankrupt many Wall Street firms - now it costs an amount equal to a half dozen good bonuses. Selling food to Spain involved negotiating with the Opus Dei (a conservative Catholic sect controversial in part for backing authoritarian right-wing governments). And where American Express insisted that all divisions make at least $500,000 in profit.

But it was surprisingly similar in various ways as well. People worked within their narrow domain and when it didn't make sense they didn't rock the boat. People could be bought-off by surprisingly small profit streams. And when it all went wrong they went back to business as usual without much introspection as to their stuff-ups.

Moreover the really large stuff-ups and frauds could then (as now) be avoided with common sense (something that is surprisingly uncommon).

Background

Tino De Angelis was a Bronx boy, son of Italian immigrants, who found a job in the meat and fish market and rapidly found success. Mostly that came through circumventing government regulation or ripping off government programs. His first fortune was black-market meat with war-time rationing - though he was never prosecuted. The vegetable oil business for which he later became famous (and which is the subject of this book) arose from quirks in the Food for Peace program, a program which was ostensibly about aiding the beaten up economies of Europe but was just as much about subsidizing farmers.

Tino's first company was Gobel, a meat-packing concern which had frequent enough clashes with the government, the first major one being over the sale of 18,900,000 pounds of smoked meat to a school lunch program. [The weights were wrong...]

Later Gobel was prosecuted by the SEC for overstated profits - then understated losses and for borrowing money against inventory that didn't exist. The book doesn't spell it out so clearly but Gobel either overstated revenue or understated its expenses producing fake profits. Fake profits would normally be held in the balance sheet as fake cash however that was too easy for auditors to find so the fake cash was converted into fake inventory. Just to add insult Gobel borrowed money against non-existent inventory.

Nobody went to prison for that but the Justice Department later prosecuted Tino for perjury and destroying evidence, however the prosecution case fell apart at trial when the key witness recanted.

Tino then entered the business of exporting vegetable oil from the US. Most of the "oil crushers" were in the Midwest and exported via the Great Lakes or Mississippi, but Tino established the Allied Crude Vegetable Oil Refining Corporation (Allied) at Bayonne New Jersey in a port facility with some reconditioned petroleum refining tanks. He had to be there - it was closer to Manhattan and the money and status of Wall Street.

The (privately held) Allied seemed to be profitable and accrued large tax bills, however like at Gobel the profit was an illusion - it was spent on endless inventory and some overstated plant - and like at Gobel the inventory was illusory.

Like at Gobel there was an undertone of ripping off the government, some of which was done through "Food For Peace" program. An early example was the (subsidized) shipping of a million tonnes of feed grain to Austria for feeding pigs. The population of Austria was seven million so this is 140 kg (over 300 lbs) per man, woman and child. As an official investigating later observed everyone in Austria would have been truly sated on pork chops. [The grain was then sold at very low prices on the black market to East Germany - the then cold-war enemy. This is an extension of the war-time rationing cheats De Angelis grew rich on.]

Also like Gobel there was extensive borrowing against phantom inventory.

Most of the book is about how the borrowing took place. The key however was that American Express had a warehousing business which issued receipts confirming that commodities (oil, grain, vegetable oil and other commodities) had been delivered to warehouses and were stored safely. Finance was offered by at least fifty banks against these receipts. [This sort of finance, including finance for cargoes on ships, is common enough and usually goes under the rubric of "trade finance".]

In this case the warehouses were on the Hudson river, used to contain petrochemicals and were now filled with sea-water topped with a thin layer of vegetable oil. In each tank there was a tube built over the testing hole - and that tube which went to the bottom of the tank was also filled with vegetable oil. Depth-tests of the vegetable oil showed the tanks were full.

Over $100 million worth of these receipts were issued. Allied also stole an American Express receipt book and forged additional receipts. Many of the forged receipts were held by brokers (especially Ira Haupt & Co) as collateral for futures contracts buying still more vegetable oil.

A lesson of the book: corrupting people is inexpensive especially when they are only a small cog in a big wheel. It is very difficult for say a warehouseman to take an honest job if it involves a sixty percent drop in his salary. [Corollary - you have to cut Wall Street bonuses a long way before you make corruption unattractive...]

The collapse of Ira Haupt & Co

The forgotten part of the scandal is the collapse of a small Wall Street broker - Ira Haupt & Co. Ira Haupt paid $18 million in margin calls on behalf of Allied (secured by fraudulent warehouse receipts) and thus the futures exchange had no loss. Ira Haupt however was bust.

Because the Chicago commodity exchanges had no loss they behaved holier-than-thou taking no responsibility for their (moderate) duplicity. But the New York Stock Exchange was terrified. The text has resonance even today:

[T]he stock exchange officials feared with good reason that if they did not help Haupt, there might be a widespread loss of confidence by investors in the integrity of brokerage firms. Haupt's 20,700 customers had left stocks worth more than $450 million in the safekeeping of the firm. Almost $90 million of these stocks had been purchased partially on credit and, as was entirely proper, Haupt had pledged these stocks to banks for loans. Customers also had left $5.5 million in cash on deposit with Haupt.

Haupt was bailed out, a bail-out largely forgotten because it happened the weekend President Kennedy was assassinated.

The collapse of Haupt however led to the establishment of the first Wall Street fidelity fund. It was settled with the quaint sum of $25 million.

This book is refreshingly jargon-free. And the human foibles that make great scandals possible haven't changed much. Nor has their vulnerability to common sense.

When Allied collapsed the stocks of vegetable oil at Bayonne and in futures contracts were more than a year's supply. To avoid this one you only needed to ask the right questions.

John

PS. Several prices amuse me. Soya oil was typically about 7.5-8c per pound (say about $180 per tonne). A Cadillac cost $6000 - about 33 tonnes of oil. A New York apartment suitable for a mistress [the measure in the book] cost about $15000 (or 83 tonnes of oil).

Soya Oil is now about 40c per pound. The Cadillac costs $75000 or about 85 tonnes of oil. The New York apartment costs maybe $1.5-2 million or over 1700 tonnes of oil. New York apartments measured in vegetable oil have been twenty baggers.

This accords with other observations. Australian farmers have gone from being the richest people in the world to having difficulty sending their children to city schools. Warren Buffett (befitting someone his age) tends to compare businesses to the yield on farm land whereas nobody else on Wall Street would have any idea what the yield on farm land is.

--

PPS. The book - purchased on Amazon - came with two bookmarks. The first was a computer punch card (the first I have seen in more than a decade). The second a business card.

J. Victor Herd was an important person in New York insurance in the 1950s to 1970s. He warranted a long obit in the New York Times. The Continental Insurance Companies may have once been headquartered downtown but are now firmly in Chicago (as part of CNA). This is just another example of the decline of "Downtown".

The business card is old school. There is an address but no phone number (his secretary would have worked out whether you were worth his time) but only after you looked up the phone number in the white pages and were directed through the switchboard. (Correction, there is a phone number with an area code being LL...)

I am not sure when they retired the musket-soldier image. These are now collectables on Ebay.

Monday, December 2, 2013

I recently purchased a subscription to Microsoft 365 Office Home Premium for AUD12 per month.

And I just received my first invoice.

It came by traditional snail-mail from Singapore to Australia.

I can't even begin to grasp the level of management dysfunction that allows a tech giant to put a piece of dead tree through a printing press, into an envelope and onto a jet plane every month to give an unwanted receipt for an amount equal to three coffees.

This is more than a decade after Bill Gates said that the internet was central to everything that they were going to do.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.